Transactions

Cap Rates Fall in Secondary and Tertiary Markets

The spreads are now more in line with those in the six major metros.

In 2015, apartment cap rates, at least in the six major metros, finally found a floor, according to a recent report from Real Capital Analytics (RCA).

Despite a drop in December that RCA said could just be “monthly noise,” cap rates continue to hover at the 5% floor they hit in mid-2014.

That could be a function of investors looking at other locations and product types.

“We’re advising our clients to look more closely at Class A and value-add suburban deals for better risk-adjusted returns at this point in the cycle,” says Jay Parsons, director of analytics for MPF Research. “In this segment, pricing hasn't skyrocketed near to the degree seen in core urban deals, and returns have historically been better than what many investors perceive.”

Investors seem to be taking note. RCA cites “some ongoing cap rate compression” in secondary and tertiary markets. That’s helped bring spreads more into line with those in the six major metros.

“The spread between cap rates for mid- and high-rise assets in secondary markets and the six major metros peaked at 140 basis points in 2014 but came in as secondary cap rates compressed and was flat in the 75 basis point range for 2015,” RCA wrote in the report. “With garden apartments, the spread continued to narrow, to below the 120 basis point range by year end. The spread was in the 60 to 80 basis point range as recently as 2011.”

Into 2016, questions won’t just be about the cap rate spread between the six core markets; they'll be about how the Federal Reserve’s December decision to raise the fed funds rate target range to 0.25%–0.50% will affect cap rates and, more broadly, the apartment transaction market.

“Clearly, interest rates are very important to real estate prices, and the reality of a rising interest rate environment will be a headwind for the market in 2016 and beyond,” RCA wrote in a December report.

But so far, fear of any major shift in valuations seems to be muted.

“The consensus seems to be that the impact to apartment sales will be minimal, and I don’t see reason to disagree,” Parsons says. “Spreads on apartment deals are still attractive relative to previous cycles, even with a modest bump in interest rates.”

The reason for that could partly be the often-repeated theory that the historical relationship between the 10-Year Treasury note (also known as the T-bill) and cap rates may have been altered over the past decade.

The spread between the cap rate and the T-bill was at 300 basis points when the rate change was announced, while the historical spread is about 140 basis points, according to Axiometrics.

“Since the Great Recession, there has been a dislocation between cap rates and the 10-Year,” says Axiometrics senior real estate economist KC Sanjay.

Even with the rate hike, borrowing costs remain historically low.

“Rates are still well below normal levels—and probably will be for the foreseeable future,” Parsons says. “Plus, there still aren’t a lot of better options for yield-hungry investors.

"If apartment sales actually slow, it’ll likely have more to do with questions about the maturity of the cycle.”